Adjustable rate mortgages (ARMs) were blamed by some financial commentators for the rise in foreclosures, so many homeowners are wary of them. Indeed, only 5 percent of mortgage applications at the end of 2010 were for ARMs. While it's true that ARMs are a bit more complicated than fixed-rate loans, in an environment of rising mortgage rates, ARMs are especially worth a second look if you're refinancing.
ARMs offer low initial mortgage rates
Most homeowners interested in refinancing are seeking the lowest possible mortgage rate. This is why ARMs--which tend to have lower interest rates than their traditional 30-year, fixed counterparts--are popular when market interest rates are high. In such periods, mortgage borrowers looking to minimize their monthly payments find initial ARM rates quite attractive. With today's mortgage rates still holding at historical lows, most consumers prefer to lock in a low rate for the long term.
However, many refinancers in today's market would actually come out ahead if they chose an ARM. This is particularly true now that mortgage rates have begun to climb at the end of 2010.
"The gap has widened between loan types over the past few weeks, with fixed-rate, 30-year loans over 5 percent while 5/1 ARM rates are at 3.6 percent," says Keith Gumbinger, vice president of HSH.com. "When the differential is greater between the two loan types, it adds to the argument that ARMs are worth considering."
ARM advantages for refinancing
A big reason to refinance into an ARM is to take immediate advantage of low mortgage rates in the initial fixed-rate period. Another compelling reason to refinance into an ARM is if you plan to sell your home before the loan adjusts.
"If you know the end period when you will sell your home or pay off the loan in full or refinance, an ARM can be a good loan," says Douglas Benner, a senior loan officer with Embrace Home Loans in Rockville, Md. "Some people know for certain they are retiring to another home within a few years, or they know they will come into some money or be transferred to another area. In that case, it makes sense to save the money in interest payments during the initial few years of the loan."
Gumbinger says another candidate for an ARM refinance is a homeowner who is waiting for the economy to recover or for their personal financial situation to improve. For this kind of homeowner, an ARM provides valuable short-term stability.
"This can be a great product to 'tide you over' for a few years as long as you save money while you are using an ARM," says Gumbinger. He cautions that this strategy comes with some risk, however. "It is a reasonable guess that mortgage rates will be higher in the future since they are so low now. Even though people have a plan for when the fixed-rate period ends, they should be prepared for the possibility of the plan not working out."
Gumbinger says borrowers should game out best-case and worst-case scenarios for the loan adjustment so they can have realistic expectations about potential monthly payments.
How ARMs work
ARMs start out with a fixed-rate period, often one, three, five or seven years. During this initial loan period, the ARM is essentially a short-term fixed-rate loan. Gumbinger says that ARMs with longer fixed-rate periods typically have slightly higher mortgage rates.
After the fixed period, the mortgage rate adjusts according to the loan terms. One of the major determinants to the adjusted interest rate is the index to which the mortgage is linked.
"Most ARMs are adjusted according to the LIBOR (London Interbank Offered Rate) index, a market interest rate which is based on the global economy, and some are adjusted according to Treasury securities, which are more closely tied to Federal Reserve decisions," says Gumbinger. "Studies have shown that both of these indexes end up in about the same place over time, but borrowers should ask about the index and understand how it works."
Understanding ARM terms: Margins and caps
Benner says that borrowers need to understand the margins and the caps that control an ARM before choosing one.
"A critical piece of information for borrowers is the margin, which states whether the mortgage rate can adjust by 2 points or by 2.75 points at each reset," says Benner. "Shopping the margin is as important as shopping the mortgage rate."
Benner says that most ARMs today have a "5/2/5" cap, meaning that the rate can go up 5 percent at the first reset. The second number refers to a maximum rate increase of 2 percent at each reset interval. The final number sets the maximum mortgage rate increase over the life of the loan. In other words, if a borrower takes on an ARM at a 4 percent mortgage rate, the mortgage rate can never rise above 9 percent if the loan comes with a 5 percent lifetime cap.
Saving money and building security
Saving money during the fixed-rate period of an ARM can be a good way to build security for the future, as long as you understand the three most important parts of your ARM: the index, the margins and the caps.
As with any mortgage loan, understanding the loan is key to making an informed decision. The mistake you shouldn't make is to ignore the benefits of ARMs entirely without understanding the very real benefits they bring to the right borrower.
Michele Lerner is a freelance writer with twenty years of experience writing articles and web content for newspapers and magazines on topics related to real estate, personal finance and business. Her clients include The Washington Times, Urban Land Magazine, NAREIT's Real Estate Portfolio, and numerous Realtor association publications.